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Jefferies Report: Margin Expansion of IT Cos. in FY25 Faces Significant Hurdles

Published 06/09/2024, 01:46 AM
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Jefferies' latest report casts doubt on the anticipated expansion of EBIT margins for IT companies in FY25. The consensus expectation is an 80 basis points (bps) year-on-year (YoY) increase, reaching 20.3% for the sector. However, while there’s optimism for a significant 380bps improvement (240bps adjusted for one-off items) in Tech Mahindra (NS:TEML) (TechM), the outlook for other IT firms suggests only a modest 20-80bps rise. Jefferies highlights several challenges that may prevent these margins from expanding as expected, posing potential risks to earnings.

The report underscores a concerning trend in the employee demographics of top IT firms like Tata Consultancy Services (NS:TCS) and Infosys (NS:INFY). The share of employees under 30 years old has decreased to its lowest point in five years. This shift towards an older workforce, coupled with near-peak utilization levels, suggests a less agile and more costly employee structure. With demand remaining lukewarm, these firms may struggle to reverse the trend quickly. Consequently, the deteriorating employee pyramid and high utilization rates could impede margin growth.

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Jefferies notes a significant reduction in subcontracting costs across the sector. Currently, these costs are at their lowest since FY15, constituting 9.1% of sales, a 230bps drop from their peak in FY22. This reduction reflects efforts by IT firms to cut expenses amid subdued demand. However, with subcontracting already minimized, there is little room for further cuts. Exceptions include Infosys and TechM, where subcontracting costs remain relatively higher but still near their five-year lows.

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The report also highlights valuation issues for giants like TCS. According to InvestingPro's fair value assessment, TCS is priced at INR 3,439 per share, while its current market price (CMP) is INR 3,893, indicating an overvaluation of 11.7%. This discrepancy poses a risk for investors, suggesting that the stock may be overpriced.

However, utilizing fair value metrics, which adjusts with market developments, can help investors make timely decisions. Once a stock's fair value surpasses its CMP, it might be prudent for investors to consider booking profits and reallocating their investments to companies with more favorable valuation gaps.

Jefferies' analysis suggests that the anticipated margin expansions for IT firms in FY25 might not materialize as expected. Factors such as an aging workforce, near-peak utilization, and already minimized subcontracting costs create significant barriers to margin improvement. Additionally, valuation concerns raised by InvestingPro, particularly for major players like TCS, add another layer of risk for investors. Staying informed through fair value assessments can help navigate these challenges and optimize investment strategies.

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